Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 17

Value investing and valuing a business

Originating from the economist and investor Benjamin Graham, the philosophy of value investing has been a strategy employed by some of the most successful investors in history including Warren Buffet and David Dodd. This approach revolves around investing in stocks trading at a discount to their intrinsic value but there is always one critical question inherent in this investment philosophy; what valuation multiples do you use to identify the intrinsic value of a company?

Selecting valuation multiples

Unfortunately there is no single method of valuation and it is subjective whether an investor places more importance on current assets and earnings or on future cash flows and growth prospects. Over the years there have been opposing thoughts. Modern Portfolio Theory argues that due to the Efficient Market Hypothesis, all stocks trade at their fair value and it is impossible to identify undervalued shares. Yet it is widely agreed that value stocks have consistently outperformed growth stocks in the long term and some of the most successful investors have continued to outperform the market by identifying companies that are trading at a significant discount to their intrinsic value.

Keeping in mind that there are a range of multiples and valuation models that can be employed in value investing, there are some key factors that are often considered in valuing a business.

When we qualitatively analyse the quality of a business, the fundamental drivers of value include the company’s management team and their experience in the respective sector, the company’s strategy and plans in place for the company’s expansion. Translating this to quantitative drivers, return on equity and capital, debt to equity ratios and cost of capital come into play. A value investor should also take into consideration accounting policy differences which can skew profit multiples, and can lead to misleading valuations of companies in comparison to its sector. Depreciation, goodwill, provisions and deferred tax should be considered. As a result, a company’s cash flow is a good metric for valuation as it is free from accounting distortions and its EBITDA is a suitable measure to assess profitability.

The Price to Earnings (PE) Ratio is one of the most common multiples used by the retail investor to indicate if a share is over or undervalued but this can be misleading for a few reasons:

  • earnings are subject to different accounting policies
  • different capital structures will lead to a gearing effect on the earnings which will skew results for different companies
  • a low PE could be a sign of negative market sentiment towards the stock rather than a reflection of the stock being undervalued.

The Price to Book Value, which represents a company’s share price over its book value, is often used to value a business where value is generated through its tangible assets. This is where Return on Equity comes into play. Financial stocks, especially banks, are often valued using the Return on Equity ratio due to their high levels of leverage from deposits coupled with significant assets through loans. Return on Equity can reflect how efficiently a company utilises shareholders’ equity to produce profit, as well as how effective the company manages its debt and asset turnover. A company with a consistently increasing Return on Equity and a decreasing debt level is often a sign of an effectively-managed business.

After analysing these key valuation multiples, investors should gain an in-depth understanding of the company’s business model and its sector to make a more informed investment decision.

What to look for in listed companies

My golden rules for investing are:

  1. Make informed and educated investment decisions
  2. Know why you are buying shares in the company
  3. Do not speculate
  4. Invest only when there is an opportunity
  5. Invest in quality companies with great future prospects
  6. Understand the business before investing
  7. Have an exit strategy
  8. Have patience and discipline.

Value investing is a strategy used by some of the most renowned investors in history and is a proven approach that can help the medium to long term investor identify undervalued businesses. The market is dynamic and volatile and investors should have a clear strategy and direction before making any investment decision. An individual should invest in quality stocks that are trading below their intrinsic value with a target in mind.

Michael Kodari is Managing Director of Kodari Securities (KOSEC).

 

RELATED ARTICLES

Quality over quantity: a lesson of value

Don’t go swimming naked for a short term thrill

banner

Most viewed in recent weeks

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Welcome to Firstlinks Edition 467

Fund manager reports for last financial year are drifting into client mailboxes, and many of the results are disappointing. With some funds giving back their 2021 gains, why did they not reduce their exposure to hot stocks when faced with rising inflation and rates?

  • 21 July 2022

Welcome to Firstlinks Edition 466 with weekend update

Heard the word, cakeism? As in, 'having your cake and eating it too'. The Reserve Bank wants to simultaneously fight inflation by taking away spending power, while not driving the economy into a recession. If you want to help, stop buying stuff.

  • 14 July 2022

Welcome to Firstlinks Edition 465 with weekend update

Many thanks for the thousands of revealing comments in our survey on retirement experiences. We discuss the full results. And with the ASX200 down 10%, the US S&P500 off 20% and bond prices tanking, each investor faces the new financial year deciding whether to sit, sell or invest more.

  • 7 July 2022

Latest Updates

Financial planning

Five charts show predicaments facing financial advice

The number of financial advisers in Australia has almost halved at a time of greater need than ever. What has happened to the industry and its clients as yet another Quality of Advice Review takes place?

Property

House price doomsayers: Could housing prices really fall by 20%?

Why do house prices move in an up-and-flat pattern rather than up-and-down like shares? When house prices start to fall, supply reduces to create a new equilibrium, rather than needing even more price reductions.

Latest from Morningstar

Why I’m not ready for an SMSF

SMSFs are increasing in popularity among younger investors, drawn by the investment control and fixed costs. But until a sufficient balance is achieved, it may be better to stay with a large fund.

Investment strategies

Six ways to take a ‘private equity’ approach in listed markets

By taking a private equity approach to investing in the public equity markets in this difficult market, investors can harness the 'best of both worlds' and still make superior returns over the long term.

Investment strategies

How to avoid being a bad investor

It's tough to become the 'best' investor in the world, but we can certainly avoid being the 'worst'. Here are graphical examples of some long-term principles to adopt, including the difficulty of timing the market.

Financial planning

The case for closing the financial gender gap

While the gender pay gap is slowly improving in the workplace, ATO data shows Australian men aged 55-59 average $50,000 more in super than women of the same age. Financial advisers have a role to play.

Property

Three opportunities in property in Australia and APAC

Rising interest rates and occupancy threats have reduced the share prices of many property companies and trusts, but the selling underestimates the strong pockets of demand and robust earnings from good tenants.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.